Crypto, mania, and reflexivity

A few weeks ago, I started looking at a bitcoin tangential play, and as part of that process I started going further and further down the bitcoin / crypto rabbit hole.

Long time readers will know that I’m a long time crypto skeptic. Admittedly, I remain one…. but the more time I spent looking at bitcoin, the more I thought about the Soros quote “When I see a bubble forming, I rush in to buy, adding fuel to the fire. That is not irrational.”

It feels like a bubble is forming in crypto / bitcoin…. but we’re just at the start of it. It’s hard for me to see how things don’t get a lot crazier in the short to medium term (just writing that made me feel uncomfortable, so I’ll throw out a quick reference to our disclaimer / reminder that nothing on here is investing advice!)

I understand this is coming a little late to the party. Bitcoin’s up ~50% over the pats month, and plenty of investors have been predicting a crypto bull cycle over the past few months. The thesis was simple: SEC adoption of a bitcoin ETF + the upcoming “halving” (where rewards for mining crypto get cut in half) would drive an upcycle in crypto.

Personally, I was always skeptical of those predictions. I generally think widely known events get priced into stocks; Bitcoin’s halvings are about the most known thing out there (they were all scheduled when Bitcoin was created so you’ve known about them literally since creation), and it’s been obvious for a while a Bitcoin ETF was coming eventually (plus, given there were already Bitcoin ETFs using futures plus it’s not like it was hard to get exposure to Bitcoin if you really wanted it, I wasn’t sure how the introduction of a Bitcoin ETF could really drive price).

With bitcoin up just shy of 50% YTD, my skepticism has proven wrong / the calls for an upcycle have proven right so far.

Source: KoyFin (YAVB readers get a 20% discount on KoyFin memberships)

So I’ve been skeptical (and wrong) on crypto (both overall and in terms of this year’s specific catalysts). Why do I think things could just be getting started?

Two reasons.

First, manias can become reflexive. Bitcoin ETFs make it really easy for financial advisors to add crypto exposure… with Bitcoin up ~50% since the ETFs launch, crypto is about to become a selling point for financial advisors. That is a huge advantage for advisors who are early adaptors. If an advisor instantly put a 2% allocation into crypto when the ETFs got approved, they are now outperforming the index by ~1%. Now they can go to all their clients and potential clients and say, “We’re outperforming the index because we’re embracing the future; do you really want to be stuck with an advisor who doesn’t give you any crypto exposure?” That’s a pretty powerful sales pitch; it probably leads to inflows from advisors with no exposure to advisors with exposure, or (at minimum) encourages advisors without exposure to adopt some exposure to compete (even if it’s a small amount from a sales point of view). Either way, that results into an inflow into crypto. And, remember, this inflow is reflexive: if bitcoin had stalled out or gone down post ETF offering, it wouldn’t have resulted in this sales pitch. Instead, it skyrocketed, creating a wild sales pitch and a huge incentive for advisors to get on board.

I think that reflexivity is a nice touch…. but the main reason I think the crypto / bitcoin party could just be getting started is how the bitcoin derivative trades have done since the ETF was offered.

Before the bitcoin ETF was offered, there was no easy way for equity focused managers to get bitcoin exposure. The best way was probably to buy the Grayscale Bitcoin Trust (GBTC), but it was a closed end fund with a large expense load, so the discount to NAV could swing widely. The second best way was to buy a company that was investing in Bitcoin in some way. The poster child for this pivot was MicroStrategy (MSTR), which had turned Bitcoin into basically their corporate reserve and was making an all-in bet on Bitcoin, but there were / are several other companies with similar themes / exposures.

It’s the second set of companies that really interest me here. Because there was no easy way to trade Bitcoin, derivative plays like MicroStrategy often traded at a premium to NAV. For example, just before the bitcoin ETFs got approved, this VIC write up estimated that MSTR was trading at a >20% premium to the value of its Bitcoin.

I would have expected that when Bitcoin ETFs got approved, derivative plays would stop trading for a premium. After all, if you want bitcoin exposure, why buy a derivative play when there’s now an easy equity way to buy bitcoin basically directly? In fact, I’d have guessed derivative plays would start trading at a discount post ETF approval. After all, owning Bitcoin in a company structure is really inefficient on a whole host of levels (particularly taxes; if you buy and sell bitcoin, you’ll get hit with capital gains taxes…. but if you own a company that buys and sells bitcoin, they’ll get hit with capital gains taxes and then you’ll be hit with capital gains taxes on top of it!). So, at minimum, I’d have expected the premiums to go away.

So far, the opposite have happened. Crypto derivatives have screamed higher. MSTR is up >115% so far this year, more than doubling the gains of Bitcoin (note I pulled this over the weekend; I’m publishing this on March 4th and MSTR is up ~25% while BTC is up ~5% so the discrepancy is even larger now). Other derivative plays are up something similar.

Source: KoyFin (YAVB readers get a 20% discount on KoyFin memberships)

This is where the reflexivity kicks in: with all of the derivative plays trading at huge premiums, they have a little bit of a perpetual motion machine to buy bitcoin. Consider a hypothetical company that owns $5B of Bitcoin but trades for a market cap of $10B. Their stock is pricing their bitcoin at 200% of face; issuing stock to buy more bitcoin is an incredible capital allocation decision. If they issue 20% of their stock at market prices, they can increase their bitcoin holdings by 40%! Issuing overvalued stock to buy bitcoin isn’t just a great capital allocation decision, it’s a smart decision for corporate executives (they’re now in charge of a much bigger organization, which comes with all sorts of increased perks and reputation burnishing, as well as the likely hood of a pay bump!).

That’s the type of math all of these bitcoin derivative plays are looking at right now. And all of them are taking advantage of it. They all have huge ATM (at-the-market) programs to sell stock on the open market; all of them are doing it actively. To use just one example, MSTR disclosed at the end of February that they’ve issued $137.8m shares of stock since the beginning of this year. Basically all of those proceeds have gone into Bitcoin (that 8-k discloses they bought $155m of Bitcoin from Feb. 15-25, bringing their YTD Bitcoin purchases to just shy of $200m). Again, that’s a great trade: MSTR is issuing stock at a premium to buy bitcoin.

If it was just MSTR doing that trade, it wouldn’t matter…. but, again, almost every crypto derivative trade I’m aware of is trading at a premium, and all of them are pursuing a similar “issue stock at a premium to buy bitcoin.” And this is where I think my unique angle is; I’ve seen plenty of people talking about ETF buying driving increased demand, but I haven’t seen any people talking about how many derivative plays are issuing stock at huge premiums to suck up incremental BTC.

Combine that buying with the advisors pouring into ETFs, and you have the potential for some real fireworks. And, even with Bitcoin up ~50% so far this year, it feels kind of early. On the “real investor” side, you’re probably pretty early in the “advisor needing to allocate something to crypto if only for marketing / sales reasons” cycle, and on the crypto side, most Bitcoin investors are still bulled up that we’re going to have a run at least into the halving in April. So yes, crypto has run a lot…. but that combo kind of feels to me like it’s early.

There’s one other interesting dynamic at play here. Most manias tend to end when supply just overwhelms the demand. The SPAC bubble ended, in part, because we started seeing 5-10 SPAC IPOs every day (the SEC changing guidance on SPACs helped too!). The Archegos squeeze of ViacomCBS (and a few other companies) ended when Viacom offered stock. The Dotcom bubble burst after averaging more than 1 tech IPO a day for several years.

The interesting thing about Bitcoin is there’s no new supply that can come online for Bitcoin. In fact, the current rip is reducing the Bitcoin supply. Companies like MSTR tend to hold all of the Bitcoin they buy on their balance sheet. In fact, MSTR doesn’t just raise equity to buy and hold Bitcoin…. they’ve made clear their goal is to raise equity and lever it to buy and hold Bitcoin (I’ve got a lot of quotes below, but I’ve excluded the simplest / most telling, which was “We're going to do everything we can to acquire more bitcoin”):

Source: Tegus (YAVB readers can get a free trial by signing up here)

So, in the short term, any money that MSTR (or many derivative companies like them) raise to buy bitcoin is actually going to be reducing the Bitcoin supply.

And it’s worth noting that FASB recently adopted rules that require entities to report fair value of Bitcoin price swings on their income statement.

So, in the short term, things can get pretty crazy. Bitcoin maximalists are excited into the halving in April. Bitcoin derivative plays can raise money at a premium to go buy bitcoin, and they can often leverage it to buy even more bitcoin. Traders are willing to pony up money for those derivative plays because the stocks keep going up and bitcoin going up makes it pretty clear the derivative plays are going to report insane earnings in the short term. Since these players tend to hold on to all or most of the Bitcoin they buy, the combination continuously reduces the float of bitcoin, sending the price up. As bitcoin’s price goes up, advisors who have allocated to bitcoin outperform, letting them poach clients from advisors who haven’t and creating pressure on other advisors to open some allocation to bitcoin.

In the short term, that’s a perpetual motion machine. Like all manias, that perpetual motion machine eventually runs out. Maybe the machine runs out tomorrow; as I write this, Bitcoin is trading for ~$63k, giving it a “market cap” just shy of $1.25 trillion. That’s a huge number!!!! It’s hard to keep a motion machine alive at that big a number. Maybe the machine runs out in April post-halving, maybe it runs out after bitcoin options get approval, or maybe the machine stops because a butterfly flaps their wings at the wrong time two years down the line. Who knows? (My guess would be: it runs out when BTC’s price starts to stall out; that causes the premiums to dry up as people get less excited by the derivative plays…. but the question is if it stalls out now, three months from now, or three years from now, and if BTC is at $60k or $160k or $600k when it happens, and I don’t have any views on any of those!).

Again, I’m a crypto skeptic. I’m not making a call on Bitcoin’s fair value, or the fair value of any of the derivative plays. I’m not making any calls at all (to be honest, I’m mainly interested in some derivative plays I have not mentioned that I would consider really inferior that are trading at huge premiums, but that’s a story for another time….)…. but the more I dove in here, the crazier the motion machine here seemed to me, and it still feels like we’re early into this ramping up.

Consider: Bitcoin’s last peak was in late 2021 at ~today’s levels (~64k/coin). At the time, there were ~19m bitcoin’s outstanding. Today, there’s 19.6m, so the supply has increased by ~600k coins. In late 2021, MSTR held ~125k Bitcoins; today, they hold 193k. MSTR alone has soaked up >10% of the supply increase; add in some of the other publicly traded derivative plays, and you could argue all of the increased supply has been taken up by derivative plays…. and that’s before factoring in all the new demand from ETFs.

Bitcoin may be back to its 2021 highs, but it feels like the squeeze here is just beginning. It could be a wild ride. Buckle up (and feel free to let me know if you think I’m just way off in either direction here!).

PS- The bell at the top is generally wrung when the last person capitulates. I am admittedly a crypto skeptic, and it feels to me like crypto is going to get a lot crazier…. so if you want to use me as a contra, by all means go ahead and I will happily eat crow if Bitcoin goes down 50% and I’m getting quote tweeted this article in a few months!

PPS- another way that supply often kills mania is you just get tons of copycat companies. So, if AI is rampant, you get a ton of AI companies IPO’ing and they all compete with each other. The interesting thing about bitcoin derivatives trading at a premium is any copycat company needs to buy bitcoin and (again) there is no new supply of bitcoin. So, in the medium term, eventually they just overwhelm the supply of money and the premiums have to vanish, but in the short term the supply coming online to meet demand can be overwhelming as it chases bitcoin if all of these guys are doing so with the promise to hold bitcoin on their balance sheet. Now, maybe we’re already in the late stages of that cycle, but it does feel kind of early to me given how big the premiums have started to get….